What To Do If You Inherit An IRA

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Americans have a staggering $7.9 trillion in Individual Retirement Accounts. If you inherit a slice of that pie, be careful: The tax laws surrounding inherited IRAs are complicated and mistakes can be costly. So, do nothing until you study up on the tax rules.

Is it a traditional pre-tax IRA or a Roth IRA? Did you inherit it from a spouse or someone else? Did you inherit an inherited IRA? All these factors determine how long you can keep the money in the IRA on a tax-deferred basis (if it’s a traditional IRA) or on a tax-free basis (if it’s a Roth IRA).

Let’s say you inherit a pre-tax IRA from a parent and cash it out. The full amount is immediately taxed as income to you. That could drive you into a high tax bracket, with Uncle Sam grabbing 40% of your inheritance. And once you’ve taken out the money, you can’t put it back in an IRA. It’s an irrevocable taxable distribution, warns Kaye Thomas, a tax lawyer and author of Fairmark.com’s Tax Guide for Investors.

Here’s a better option: Leave the money in the IRA and ask the custodian to retitle it as an “inherited” IRA. Example: Tom Jones, deceased, inherited IRA for the benefit of Sally Smith, beneficiary. You must start taking annual taxable withdrawals in the year after your parent’s death. But these are small payouts, calculated so the IRA will likely last your entire life. (Note: The percent you take out is based on your life expectancy as of the year after the IRA owner died, so you could exhaust it before you die, unlike your own IRA which will last your lifetime because the distribution amount is recalculated each year based on a revised life expectancy—up to age 111).

What’s important to focus on is this: By choosing lifetime payouts, you can get extra years of tax deferred growth and use the IRA to help fund your own retirement. Watch out: If the original IRA died before his or her required distribution start date, and you fail to take out your first required distribution on time, then you fall into the five-year trap, meaning you must deplete the IRA within five years of the original owner’s death.

If you’ve inherited a Roth IRA, you’re even luckier. You still must take minimum payouts, but the withdrawals don’t count as taxable income, because your dad or mom already took the income tax hit. “People always think that a Roth means no RMD [required minimum distribution],” says Morris Armstrong, an enrolled agent in Cheshire, Conn. “That’s true for your own Roth IRA but not if it’s a Roth IRA that you inherited from someone else.” You can stretch out the payouts so you get them over your lifetime, but you must take the first payout by Dec. 31 of the year following the year of death of the original owner. (If you fail to do this on time, you’ve fallen into the five-year trap and must deplete the inherited Roth IRA within five years of the original owner’s death).

If you inherit a pre-tax IRA, there’s no 10% penalty for early withdrawals (like there is for taking money out of your own IRA before age 59 ½). But if you inherit a Roth IRA, there’s a picky rule that earnings can be withdrawn tax-free only beginning on the first day of the fifth taxable year after the year the Roth IRA was established, warns Thomas. That means January 1, 2018 for Roth IRAs established in 2013, for example.

What if you inherit an IRA from a spouse? Then you have a big choice. You can either treat it as an inherited IRA or roll the assets into your own IRA. With a rollover, you won’t have to start taking money out of a pre-tax IRA until you hit age 70 ½, but you will be subject to early withdrawal penalties until you’re 59 ½. If it’s a Roth IRA rollover, you can leave the money in it for as long as you want, but you may not be able to withdraw earnings tax-or-penalty free until you’re 59 ½.

What if you inherit an inherited IRA? You step into the shoes of the first inheritor when taking required payouts. Say grandpa has an inherited IRA from his sister. Grandpa dies and leaves the inherited IRA to his daughter. The daughter calculates payouts just as grandpa would have done had he been living.

If the need arises, you can take out more than the required minimum payout in any given year. But think it through first. “See how this money fits into your overall financial plan,” says Chris Hardy, an enrolled agent in Suwanee, Ga. He’s had clients use part of an inherited IRA to get a fresh start by paying off credit card debt and others use the required payouts to help with cash flow and fund their own retirement accounts. Just be aware of the tax consequences.

Make sure you take at least the required minimum distributions. If you don’t, you’re subject to a 50% penalty on the amount you should have withdrawn. Armstrong helped a new client who had failed to take the required payouts for an inherited Roth IRA get into compliance by filing for a penalty waiver with the Internal Revenue Service, which was granted, and taking the missed distributions.

Lastly, make sure you name beneficiaries for your new inherited IRA. And talk to them about the benefits of inherited IRAs and getting advice. “There are a lot of little nuances and impossible pitfalls,” says Hardy.